Jeremy Grantham: ‘How On Earth Did I Miss This!’

Jeremy Grantham says that falling oil prices shouldn’t have been such a surprise, calling it his major regret for 2014

It may be easy to understand market reactions in retrospect, but when it comes to the oil price collapse GMO co-founder Jeremy Grantham thinks we should all be embarrassed that we didn’t see this one coming – or at least notice that it was possible.

“The month-to-month gains in output from fracking could be studied. Yearly productivity increases per well were substantial… Demand was also reasonably predictable, coming in steadily a little less than earlier expected, but not much less,” he writes in the fourth quarter GMO letter. “And, yes, my major regret for 2014 is, ‘How on earth did I miss this!’ A combination of laziness and distraction is my lame excuse. What is yours?”

Oil will hit $100 again, but maybe not for five years

Jeremy Grantham argues that any demand-driven explanation of the bust is a little too contrived and demonstrates a “touching faith in Mr. Market’s foresight.” Instead, he points out that US fracking was growing so rapidly that it was taking up most of the increase in oil demand since the financial crisis, and was projected to grow faster than global demand this year. He says that investors should have been buying put options to account for the binary nature of oil prices that had been building for some time (either Saudi Arabia slashes production to support prices, or allows oil prices to plummet).

Now that the crash has happened, he says that many analysts are taking into account just how quickly fracking wells dry up. Since the marginal cost is as low as the electricity needed to run the pump, the short-term floor for oil is incredibly low in a glut situation like the one we’re in now, but fracking wells produce as much as 65% of their total output in the first year.

“U.S. fracking is unique in oil industry history in the speed with which it can turn on and off,” writes Jeremy Grantham, who expects supply to begin dropping by June.

In the five to eight year time frame, assuming global GDP growth stays on course, he expects prices to recover and represent the full cost of production, not just the marginal cost. He puts that figure at $80 today and expects it to rise above $100 in five to eight years.

Jeremy Grantham thinks Saudis made the wrong call

Jeremy Grantham disagrees with the Saudis’ decision to value market share over price support. From a purely financial perspective, he thinks they could have cut production in half and kept selling at twice today’s prices, earning just as much and leaving more oil in the ground for future production. Just as importantly, he says that for a conservative nation that values stability, it’s strange to put so many nations (Russia and Iran come to mind) under financial stress with all the unintended consequences that might entail.